Defined Benefit Plans
In a defined benefit plan, the benefit is pre-defined, and the employer bears the investment risk.
A Defined Benefit plan is a retirement plan that promises a specific monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary history and years of service, and in which the employer bears the investment risk. These plans are also known as “qualified benefit plans” or “non-qualified benefit plans”.
Traditionally, many governmental and public entities, as well as a large number of corporations, provided defined benefit plans, sometimes as a means of compensating workers in lieu of increased pay.
In the United States, Federal public sector plans are governed by the Tax Code and Federal law, while state and local public sector plans are governed by the Tax Code and state law. Thus the funding requirements, benefits, plan solvency, and participant rights and obligations vary greatly. Private sector plans are governed by the Employee Retirement Income Security Act of 1974 (ERISA).
These types of plans are best suited for individuals who are over the age of 50 and can commit to making a significant fixed contribution each year. The fixed amount, in this case, is the retirement benefit, not the contribution. Employer contributions are determined each year by market values of prior investments, how many years the employee has until retirement and other actuarial adjustments. (Contribution requirements are increased when the market does poorly and decreased when the market performs well.) Social Security is an example of a government-run Defined Benefit Plan. Learn maximizing Employee Benefits with Defined Benefit Plan and also for business to get a greater reduction in tax.
If an individual establishes a defined benefit plan, they can have other retirement plans. Businesses of any size may establish defined benefit plans, although they must annually file a Form 5500 with a Schedule B and have an enrolled actuary determine the funding levels and sign the Schedule B. Generally, the employer makes most contributions. Therefore, employers may need to dip into the company’s earnings in the event that the returns from the investments devoted to funding the employee’s retirement result in a funding shortfall. Sometimes, employee contributions are required or voluntary contributions may be permitted.
Single-employer plan or Multi-employer plan
A defined benefit plan can be either a single-employer plan or a multiemployer plan. A single-employer plan, which may be collectively bargained, provides benefits for workers of one employer. A multiemployer plan is a collectively bargained pension arrangement involving more than one unrelated employer, usually in a common industry, such as construction, trucking, textiles, and coal mining.
Some pros of these types of retirement plan are that substantial benefits can be accrued within a short time – even with early retirement, and are not dependent on asset returns. Also, defined benefit plans can’t retroactively decrease benefits and can permit participant loans, which is valued greatly at times. Individuals generally highly rate the fixed benefit provided by this type of plan, and on the employer side, businesses can generally contribute (and therefore deduct) more each year than in defined contribution plans. These plans can be used to promote certain business strategies by offering subsidized early retirement benefits.
Defined Benefit Plan with a Profit Sharing Plan
However, defined benefit plans are often more complex and, thus, more costly to establish and maintain than other types of plans. They are administratively complex and require more plan management than other types of plans. Lastly, an excise tax applies if the minimum contribution requirement is not satisfied or if excess contributions are made to the plan.
In some cases, the best option is to combine a Defined Benefit Plan with a Profit Sharing Plan. Your TRCO Consultant will work hard to ensure you can contribute as much as possible from year to year while managing your plan closely to avoid potential pitfalls such as over-funding and diminishing benefits.
WHO is an Ideal Plan Sponsor?
- Goal: Plan Sponsors looking to maximize personal retirement plan savings and achieve greater tax-efficiency than a defined contribution plan alone can provide.
- Demographic: These types of plans are best suited for individuals who are over the age of 50 and can commit to making a significant fixed contribution each year. These plan types can be applied to businesses of any size.
- Generosity: Employer contributions are determined each year by market values of prior investments, how many years the employee has until retirement, and other actuarial adjustments. (Contribution requirements are increased when the market does poorly and decreased when the market performs well.)
Support & Resources
We recognize that Defined Benefit Plan discussions can be complex. At The Ryding Company we simplify the process in two ways:
- Supporting Financial Advisors and Plan Sponsors in determining the suitability of this plan option.
- By creating easy-to-understand customized plan illustrations to explain the benefits and considerations of this plan type.